Chapter 18 & 19 & 20

Short-term Finance and Planning

Cash and Liquidity Management
Credit and Inventory Management

 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 [email protected]
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 Key Concepts and Skills

 Understand the components of the cash cycle; the

pros and cons of the various short-term financing
policies.
 Understand the advantages and disadvantages of
holding cash and the application of the BAT and Miller-
Orr models
 Understand the components of credit analysis and the
way to evaluate a proposed credit policy.
 Understand the major components of inventory
management and how to use the EOQ model.
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Chapter Outline

18.1 Tracing Cash, the Operating Cycle and the

Cash Cycle
18.2 The Flexible Policy and the Restrictive Policy
18.3 Cash Management
18.4 Credit Management
18.5 Inventory Management

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 18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle

Rearranged balance sheet identity:

Cash + Accounts receivable + Inventories + Fixed assets
= Current liabilities + Long-term debt + Equity

-> Cash = Long-term debt + Equity + Current Liabilities

– Current assets other than cash – Fixed assets

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18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle

Sources of Cash (Activities that increase cash):

 Increasing long-term debt (borrowing over the
long term)
 Increasing equity (selling some stock)
 Increasing current liabilities (getting a 90-day loan)
 Decreasing other current assets other than cash
(selling some inventory for cash)
 Decreasing fixed assets (selling some property)

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18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle
Uses of Cash (Activities that decrease cash):
 Decreasing long-term debt (paying of a long-term
debt)
 Decreasing equity (repurchasing some stock)
 Decreasing current liabilities (paying off a 90-day
loan)
 Increasing current assets other than cash (buying
some inventory for cash)
 Increasing fixed assets (buying some property)

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18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle

Operating cycle:
 Operating cycle - The period between acquisition
of inventory and the collection of cash from sale
of receivables.
 Inventory period – the time it takes to purchase
and sell inventory.
 Accounts receivable period – the time between
sale of inventory and collection of the receivable.
 Operating cycle = Inventory period + Accounts
receivable period
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18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle

 Suppose one day (Day 0), we purchase $500

worth of inventory on credit. We pay the bill 20
days later. And after 30 more days, someone buys
the $500 inventory for $650. Our buyer does not
actually pay for another 25 days.
 What is the inventory period?
 What is the accounts receivable period?
 What is the operating cycle?

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18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle

Cash cycle:
 Cash cycle – the time that lasts from when we
actually pay for the inventory to when we collect
the cash from sale.
 Accounts payable period – the time between
receipt of inventory and payment for the inventory.
 Cash cycle = Operating cycle – accounts payable
period

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18.1 Tracing Cash, The Operating Cycle
and The Cash Cycle

 Suppose all we have is the financial statement

information in the following table.
Item Beginning Ending
Inventory $400,000 $500,000
Accounts receivable $140,000 $220,000
Accounts payable $70,000 $90,000

Net sales $1,150,000

Cost of goods sold $820,000

 What is the operating cycle and the cash cycle? 16-11

 CONCEPT QUESTION 18.1

 What is the difference between net working

capital and cash?
 List five potential sources of cash?
 List five potential uses of cash?
 Describe the operating cycle and the cash cycle.
What are the differences?
 What does it mean to say that a firm has an
inventory turnover ratio of 4?

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18.2 The Flexible Policy
and the Restrictive Policy

Size of investments in current assets:

 Flexible (conservative) policy – maintain a high ratio
of current assets to sales.
 Keeping large balances of cash and marketable
securities.
 Making large investment in inventory.
 Granting liberal credit terms, which results in a high
level of accounts receivable.
 Flexible policy is costly, but it is expected to get
larger future cash flows.
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18.2 The Flexible Policy
and the Restrictive Policy
Size of investments in current assets:
 Restrictive (aggressive) policy – maintain a low ratio
of current assets to sales.
 Keeping low cash balances and making little investment
in marketable securities.
 Making small investments in inventory.
 Allowing few or no credit sales, thereby minimizing
accounts receivable.
 In opposition to the flexible policy, the restrictive
policy is cheaper but can lead to lower future cash
flows.
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18.2 The Flexible Policy
and the Restrictive Policy

Financing of current assets:

 Flexible (conservative) policy – less short-term debt
and more long-term debt.
 Restrictive (aggressive) policy – more short-term
debt and less long-term debt.
-> Take two areas “The size” and “The financing”
together, we see that with a flexible policy, the firm
maintains a high level of net working capital and
otherwise.

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18.2 The Flexible Policy
and the Restrictive Policy
Flexible policy Restrictive policy
Current Short-term Current Short-term
assets debt assets debt

Long-term Fixed assets

debt
Fixed assets Long-term
debt

Equity Equity

NWC > 0, expensive, NWC < 0, cheap, lower

higher future cash flows future cash flows 16-16
18.2 The Flexible Policy
and the Restrictive Policy
Carrying vs. Shortage Costs:
 Managing short-term assets involves a trade-off
between carrying costs and shortage costs
 Carrying costs – increase with increased levels of
current assets, the costs to store and finance the
assets.
 Shortage costs – decrease with increased levels of
current assets. They can be trading or order costs;
costs related to safety reserves, i.e., lost sales and
customers, and production stoppages.
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 CONCEPT QUESTION 18.2

 What are the differences between the flexible

policy and the restrictive policy?
 What considerations determine the optimal size of
firm’s investment in current assets?

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 18.3 Cash Management

Reasons for holding Cash:

 Speculative motive – hold cash to take advantage
of unexpected opportunities.
 Precautionary motive – hold cash in case of
emergencies.
 Transaction motive – hold cash to pay the day-to-
day bills.
 Compensating balances – hold cash in current
deposits to compensate for banking services.

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18.3 Cash Management

Costs of holding too much cash:

 The opportunity costs of holding cash (or
carrying costs) are the interest income that
could be earn in the next best uses, such as
investment in marketable securities or
certificates of deposit, saving deposits.
 The opportunity costs of holding cash increase
when the firm holds more cash, and otherwise.

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 18.3 Cash Management

Costs of holding too little cash:

 Trading costs (or shortage costs) are costs
associated with converting marketable securities
(or certificates of deposit) to cash.
 They will be also the interest and other expenses
associated with arranging a loan.
 The trading costs of holding cash increase when
the firm holds less cash, and otherwise.

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 18.3 Cash Management
Total costs of holding cash
Costs of holding cash

Opportunity
Costs

Trading costs
C* Size of cash balance
 The target cash balance is a firm’s desired cash level as
determined by the trade-off between the opportunity
costs and trading costs. 16-25
18.3 Cash Management

The Baumol – Allais - Tobin (BAT) Model:

 The BAT model is a classic mean to establish the
target cash balance.
 F = The fixed cost of selling a securities trade to
raise cash
 T = The total amount of new cash needed
 R = The interest rate on marketable securities

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18.3 Cash Management

 If we start with $C, $C

spend at a constant rate

each period and replace
our cash with $C when
we run out of cash, our $C/2
Average
average cash balance will cash
be $C/2
 Opportunity costs
= (C/2) x R
Time
 Trading costs = (T/C) x F
 Total costs = (C/2) x R + (T/C) x F
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 18.3 Cash Management

Total costs of holding cash = (C/2) x R + (T/C) x F

Costs of holding cash

Opportunity Costs
= (C/2) x R

Trading costs = (T/C) x F

C* Size of cash balance

 Under the BAT model, C  (2TxF) / R

*
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18.3 Cash Management

 Suppose the Vulcan Corporation has cash outflows

of $200 per day, seven days a week. The interest
rate is 3%, and the fixed cost of replenishing cash
balance is $5 per transaction.
 What is the optimal initial cash balance?
 What are the total costs of holding cash?

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18.3 Cash Management

The Miller-Orr (M-0) Model:

 The BAT model’s chief weakness is that it assumes
steady, certain cash outflows.
 In contrast to the BAT model, the M-O model is
designed to deal with the cash balance that
fluctuates up and down randomly.

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18.3 Cash Management

The Miller-Orr Model: $

 When the cash balance
reaches the upper control U
limit U, cash is invested
elsewhere to get us to the
target cash balance C*.
 When the cash balance .
C*
reaches the lower control
limit L, investments are
sold to raise cash to get L
us up to the target cash
balance C*. Time
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 18.3 Cash Management

 Given L, which is set by the firm, the Miller-Orr

model solves for C* and U
 s2 is the variance of net daily cash flows.
 Under the M-O model,

2
3Fσ
C 3
*
L
4R
U  3C  2 L
*

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 CONCEPT QUESTION 18.3

 What is the cost to the firm of holding excess cash?

 What is the target cash balance?
 What is the basic trade-off in the BAT model?
 Describe how the M-O model works?

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 18.4 Credit Management

Components of Credit Policy:

Terms of sale: the conditions under which a firm sell
its goods and services for cash or credit. If the firm
grant credit to a customer, the terms of sale will
specify the credit period, the Cash discount and
discount period, the Type of credit instrument.
Credit analysis: the process of distinguishing
between “good” customers that will pay and “bad”
customers that will default.
Collection policy: the procedures followed by a firm
in collecting accounts receivable.
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 18.4 Credit Management

Basic Form of Terms of Sale:

2/10 net 45
 2% discount if paid in 10 days.
 Total amount due in 45 days if discount not taken.

 Suppose you buy $500 worth of merchandise with

the credit terms of 3/15 net 30.
-> Pay $500(1-0.03) = $485 if you pay in 15 days
-> Pay $500 if you pay in 30 days
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 18.4 Credit Management

The cash flows from granting credit:

Credit Sale Customer mails Firm deposits Bank credits

is made check check in bank firm’s account

Time Cash Collection

Accounts Receivable

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18.4 Credit Management

Effects of the credit policy on Revenues:

 Delay in receiving cash from sales
 May be able to increase price
 May increase total sales

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 18.4 Credit Management

Effects of the credit policy on Costs:

 Cost of the sale is still incurred even though the
cash from the sale has not been received.
 Cost of debt – must finance receivables.
 Probability of nonpayment – some percentage of
customers will not pay for products purchased.
 Cash discount – some customers will pay early
and pay less than the full sales price.

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 18.4 Credit Management

Carrying costs of granting credit:

 Carrying costs
 Required return on receivables
 Losses from bad debts
 Costs of managing credit and collections
 Carrying costs are positively related to the
amount of credit extended.

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 18.4 Credit Management
Shortage costs of granting credit:
 Shortage costs are the lost sales due to a restrictive
credit policy.
 Shortage costs go down when credit is granted.

Total cost of granting Credit:

 Total costs are the sum of carrying costs and
shortage costs.
 Optimal credit policy is where the total cost curve is
minimized.
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 Shortage costs

 Optimal credit policy is where the total cost curve is

minimized.
 If the firm extends more credit than this point, the
additional net cash flow from new customer will not
cover the carrying costs of the investment in receivables,
and otherwise. 16-41
 CONCEPT QUESTION 18.4

 What are the basic components of credit policy?

 What are the basic components of the terms of sale
if a firm choose to sell on credit?
 Explain what terms of “3/45, net 90” mean?
 What are the carrying costs of granting credit?
 What are the shortage costs of credit if the firm has
a very restrictive credit policy?

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 18.5 Inventory Management

Inventory can be a large percentage of a firm’s

assets, but the financial manager will NOT have
primary control over inventory management.
Other functional areas (such as purchasing,
production, marketing…) will usually share decision
making authority regarding inventory.
Inventory management tries to find the optimal
trade-off between carrying too much inventory
versus not enough.

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 18.5 Inventory Management
Carrying cost of keeping inventory on hand:
 Storage and tracking
 Insurance and taxes
 Losses due to obsolescence, deterioration, or theft
 Opportunity cost of capital

Shortage costs of keeping inventory on hand:

 Restocking costs
 Lost sales or lost customers
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18.5 Inventory Management

The Economic Order Quantity (EOQ) model:

 The EOQ model minimizes the total inventory cost.
 F = The fixed cost per order
 T = The total unit sales per year
 CC = The carrying costs per unit per year

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18.5 Inventory Management

Q
 If we start with Q, spend at a
steady rate each period and
restock our inventory with Q
Average
when it hits zero, our Q/2
inventory
average inventory will be Q/2
 Carrying costs = (Q/2) x CC
 Shortage costs = (T/Q) x F Tim
e

 Total costs = (Q/2) x CC + (T/Q) x F

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 Shortage costs

Q* Size of inventory orders (Q)

 Under the EOQ model, Q* = [(2 x T x F) / CC ]1/2

 At the optimal inventory level, the carrying costs and
the shortage costs are the same, so the total cost of
keeping inventory on hand is minimum.
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18.5 Inventory Management

 Suppose we are considering an inventory item

that has carrying cost of $1.50 per unit. The fixed
order cost is $50 per order, and the firm sells
100,000 units per year.
 What is the economic order quantity?

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 SUMMARY and CONCLUSIONS

 The objective of managing short-term finance is to

find the optimal trade-off between carrying costs
and shortage costs.
 The target cash balance is a firm’s desired cash
level as determined by the trade-off between the
opportunity costs and trading costs.
 If the firm extends more credit than optimal point,
the additional net cash flow from new customer will
not cover the carrying costs of the investment in
receivables, and otherwise.
 At the optimal inventory level, the carrying costs
and the shortage costs are the same. 16-49
 HOMEWORKS
Concepts review:
Chapter 18: 1, 2, 3.
Chapter 19: 1, 2.
Chapter 20: 2, 9.

Question and Problems:

Chapter 18: 1, 2, 3, 4, 6.
Chapter 19 (page 671): 1, 2, 3, 7.
Chapter 20: 11, 12.
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